The reform of China's neglected stockmarket is just as urgently needed, and just as difficult, as that of its banks

“WHY do you want to visit the trading floor?” smiles Fang Xinghai, deputy chief executive of the Shanghai Stock Exchange. “There is nothing to see.” He is right. But this has little to do with the switch from open-outcry to electronic share-trading to which he refers, because the exchange simply replaced traders' paper slips with computers and kept everyone on the floor. The desks are mostly unmanned, however, or given over to card games. An elegant gong to greet new listings, the equivalent of New York's famous bell, gathered dust for months until a ban on initial public offerings (IPOs) was lifted in January. The only movement is on electronic wall charts tracking prices and volumes—and that is resolutely downwards.

The sense of paralysis at the heart of China's most vibrant city is easy to explain. The mainland's stockmarket is in a dismal slump. On February 1st, the domestic A-share indices in Shanghai and on the junior exchange in Shenzhen hit their lowest levels for more than five years. Even after recovering a little since, they are still down by more than 40% and 50%, respectively, from the record highs of June 2001 (see chart).

This bear market lingers despite the country's booming economy. The inattention of China's leaders to the stockmarket contrasts starkly with their obsession with bank restructuring—because the banks' troubles are easier to understand, hazards Mr Fang. But the neglect of the equity market has a high price. China has private savings of at least 12 trillion yuan ($1.4 trillion) sitting unproductively in the banks. The country also has thousands of entrepreneurial firms crying out for funds. If the stockmarket were allowed to bring the two together, it could, through better allocation of capital, both raise the efficiency of the economy and help maintain its growth rate. Instead, much of that fallow cash has found its way into property, inflating a bubble. Better still, developing China's capital markets would reduce the primacy of the banks in the financial system, making their reform easier.

Such thinking is gradually catching on in Beijing, spurred, no doubt, by the fact that share prices are so low that the government is worried that the country's 70m disgruntled, mainly urban, retail investors could take to the streets. “Investors don't have a mature understanding of the stockmarket. All hell breaks loose when the market goes down,” says a senior Hong Kong banker.

This explains a sudden flurry of initiatives to support the market. On February 21st, the China Securities Regulatory Commission (CSRC), the securities watchdog, and the Ministry of Finance announced a fund, worth up to $6 billion, to compensate investors for the bankruptcy or incompetence of local broking firms. Last weekend, regulators launched a test allowing commercial banks to set up mutual-fund arms and the week before selected insurers received the green light to invest up to $7 billion in shares. Meanwhile, the Bank of Communications, the fifth-largest lender, is said to be planning to split its IPO between Hong Kong and Shanghai. Although the bank refuses to comment, this would be a boost for the domestic market. China's better firms have so far eschewed domestic listings in favour of foreign ones.

The most intriguing rumour, hotly denied by the CSRC, is that Shang Fulin, its uninspiring head, is to be replaced by Huang Qifan, the vice-mayor of Chongqing, a big western city. Mr Huang, a former aide to Zhu Rongji, prime minister between 1998 and 2003, has proved his mettle in a few finance-related posts, and is celebrated in Shanghai for overseeing the development of Pudong, its financial district. He is also not afraid to speak his mind. Asked about a crackdown by Jiang Zemin, then China's president, on Shanghai's sleazy bars, Mr Huang said that the city didn't have enough and that visitors were short of entertainment. Under him, the currently hide-bound regulator might well undertake a long-overdue root-and-branch reform of securities markets.

It is this, not the current diet of piecemeal measures, that is needed to deal with a series of complex, interlocking problems. When the government launched Shanghai's exchange in 1990 (and Shenzhen's a year later), it regarded the stockmarket primarily as a mechanism to impose discipline on the public sector and to raise a bit of useful cash. So it sold overpriced minority stakes in mostly badly run state firms, confident that investors, with few alternatives and enamoured of China's growth prospects, would buy them anyway.

For several years they did. And with the state able to rig the market as regulator and controlling shareholder and through government-linked brokers, prices soared, reaching 60 times earnings in the summer of 2001. At that point, the government got greedy and tried to sell its remaining holdings, a plan that started the current decline. Even though it was hastily withdrawn, the threat of another mass sell-off of state shares continues to spook the market.

Four years after the first sell-off, a full two-thirds of the market's $460 billion capitalisation remains tied up in non-tradable or “legal person” shares held by state-controlled entities. This continues to distort valuations. The average A-share trades at a still-expensive 25 times earnings, even when precisely the same asset, listed in Hong Kong or New York, is priced at half that. Captive domestic investors are disillusioned, while any Chinese enterprise that can do so seeks a foreign listing.

And the market's inexorable decline has pole-axed the Chinese broking industry, which not only guaranteed investors double-digit returns but also often speculated corruptly with their funds. Most of the 130-odd securities firms are, in effect, insolvent, says Stephen Green, an economist at Standard Chartered in Shanghai and author of “China's Stockmarket” (published by The Economist and Profile Books). Only ten to 20 should survive.

Mr Fang says there is a way to solve this problem. The essential first step is to remove the leaden overhang of non-tradable shares. The trick is doing this without further bilking minority shareholders who bought their holdings at inflated prices: simply flooding the market with the state's shares would drive prices down even further. Mr Fang says simply that “we have to compensate investors for their losses”, though the central government will probably be loth to find money for this when it is spending huge sums recapitalising China's banks. Hu Xiaodong, head of the Shanghai office of Martin Currie, the biggest foreign institutional investor in A-shares, with $1 billion at stake, suggests issuing “rights certificates”, giving existing shareholders the right to buy “legal person” shares at a big discount.

If this issue were resolved, says Mr Fang, the stage would be set for further beneficial developments. Restrictions on IPOs, such as the recent ban, could be removed. He thinks that companies should be allowed to list on the basis of merit rather than government connections. That ought to improve China's woeful corporate governance, because only the best firms would attract investors. It would also encourage firms to list at home rather than abroad. After that, the focus could then switch to consolidation among the brokers and the development of equity derivatives and a proper corporate-bond market.

Two things in particular could help the brokers. Allowing them to buy foreign shares would teach them to make better judgments at home, says Mr Hu. And encouraging foreign investment would bring in foreign expertise and money. Here the CSRC has already made a start—although a mixed one. In December it let Goldman Sachs buy 33% of Gao Hua Securities, with management control and the right to raise its stake. But to get approval Goldman had to bail out investors in an unrelated broking firm to the tune of $60m.

Mr Fang says that there is a consensus within the CSRC that real reform must begin with the non-tradable shares. Shares in Shanghai Automotive, a carmaker, Handan, Wudan and Angang (all steelmakers), and Yangzi and Qilu (in petrochemicals) have risen on the expectation that they will be first to be fully privatised. An announcement looks imminent.

However, for the privatisation plan to work, rising share prices are required. On February 23rd Baosteel, a respected steelmaker, delayed a $3.7 billion share offering in Shanghai because of the weak market—hardly a vote of confidence. “We are in a bind right now,” admits Mr Fang. “In a declining market, we can't solve the problems and if we don't solve the problems the market will continue to decline.”

If the fillip that stocks have had over the past few days is sustained, the conditions for fundamental reform might soon be right. The appointment of Mr Huang as head of the CSRC would surely help. But more momentum is needed for China's stockmarket to escape its Catch-22.